Tax Planning With Disproportionate Distributions from S Corporation – Houston Tax Attorneys

There are several rules one has to meet for a legal entity to qualify as an S corporation. One of the rules is the requirement that shareholders of S corporations get identical distributions.

Because this is a qualification to be an S corporation, one might think that the consequence of violating this rule is that the S corporation election is terminated.

In Maggard v. Commissioner, T.C. Memo. 2024-77, the court confirms that the receipt of disproportionate distributions does not terminate an S corporation election and that this law is “ironclad.” This case is important as it validates the treatment for various tax planning strategies involving S corporations.

Facts & Procedural History

The case involves a taxpayer who co-founded an engineering firm. Initially, the taxpayer owned half the company’s shares, with his business partner owning the other half. The company elected S corporation status in 2002. The taxpayer brought in two new owners, and by 2005, the taxpayer owned 40% of the company, while two other individuals owned 40% and 20%, respectively.

The new majority owners started making disproportionate distributions to themselves, which the court referred to as looting the company at the taxpayer’s expense. These unauthorized distributions continued for years, with the majority owners also inflating their benefits and salaries.

The taxpayer filed suit against the other shareholders in state court, alleging embezzlement and seeking various remedies. The state court found in favor of the taxpayer, concluding that the company had indeed made unauthorized, disproportionate distributions to the other shareholders.

During this period, the company continued to file its income tax return as an S corporation, despite the apparent violation of S corporation rules regarding disproportionate distributions. The corporation also told the taxpayer that he is to report losses from the S corporation on his personal income tax returns.

The IRS audited the taxpayer’s individual income tax returns and disallowed his losses. This was on the premise that the S corporation earned a profit. Thus, the taxpayer had to pick up his share of the S corporation’s profits even though he did not receive distributions. The dispute ended up in the U.S. Tax Court.

About S Corporations & Taxes

The ability to avoid self-employment income tax for the shareholders is probably the main reason why many owners make an S corporation election.

The S corporation also offers the limited liability protection of a corporation with the pass-through taxation of a partnership. It is this pass-through aspect that allows for tax planning opportunities.

The reference to pass-through taxation refers to how the corporation itself doesn’t pay federal income taxes. Instead, the company’s income, losses, deductions, and credits are reported to the IRS on Form 1120S. Thus, the tax attributes are reported at the entity level, but there is generally no tax due at the corporate entity level. The Schedule K-1 for the Form 1120S return passes through the profits and other tax items from the business to the shareholders who report these items on their personal tax returns. The individual shareholders then report the items on their personal income tax returns, and pay any associated tax on their individual income tax returns.

These pass-through rules apply regardless of whether the S corporation makes any distributions to the shareholders. This is a common issue or, depending on your perspective, problem, with S corporations. The shareholders can end up paying income tax on profits earned by the S corporation even though they did not receive a distribution from the S corporation to pay the taxes.

S Corporation Distributions

As alluded to above, one of the requirements for S corporations is identical distributions for the shareholders. This rule comes from the idea that the S corporation can only have one class of stock. The question is what counts as one class of stock? It is generally thought that if all shares do not confer identical rights to distribution and liquidation proceeds on the shareholders, then there are multiple classes of stock.

Thus, when an S corporation makes disproportionate distributions, it risks violating this one-class-of-stock requirement. However, the regulations provide some flexibility. Treasury Regulation § 1.1361-1(l)(2)(i) states that a corporation is treated as having only one class of stock if all outstanding shares confer identical rights to distribution and liquidation proceeds based on the governing provisions for the business. This means that the By Laws or Articles of Incorporation or Organization for the entity have to provide for identical rights, including distributions. It should also be noted that the distributions do not have to be in cash.

If an S corporation’s governing documents do not have these provisions, the corporation may not qualify to be an S corporation. Failing the one-class-of-stock requirement by making disproportionate distributions could potentially result in a termination.

However, the IRS has stated in Revenue Procedure 2022-19 that it won’t treat disproportionate distributions as violating the one-class-of-stock requirement if the governing provisions provide for identical rights. This is intended to avoid tax consequences for honest foot faults (such as not having the community property spouse sign the S corp election form). That brings us back to this court case.

Disproportionate Distributions

In this case, the tax court had to decide whether the unauthorized, disproportionate distributions made by the majority shareholders terminated the company’s S corporation status.

The court focused on the language in Treasury Regulation § 1.1361-1(l)(2), which emphasizes the importance of the corporation’s governing provisions rather than the actual distributions made. The court found that the company’s articles of incorporation and by laws did not authorize or provide for disproportionate distributions. In fact, these documents clearly stated that all shares were of one class and conferred identical rights.

Despite the bad acts by the majority shareholders, the tax court concluded that the unauthorized distributions did not change the company’s governing provisions. As such, the company continued to have only one class of stock as defined by the regulations. Unfortunately for the taxpayer in this case, the implication is that he owed taxes on profits that he did not receive.

Planning With Disproportionate Distributions

While this case may sound like good news for taxpayers who inadvertently fail to make identical distributions, the implications are more wide-ranging than that. The ability to shift income to another party without shifting the obligation to pay income taxes on that income is fundamental to a number of different tax planning strategies. This is particularly relevant as the S corporation election can be made late, when the financial results are already known and the corporation can distribute tangible property to the shareholders, loans can be made to S corporations to allow losses to flow through to the owners, and tax basis can be created by guaranteeing corporate debt.

One of the most common situations tax planners work on is how to transfer wealth from one generation to another while paying as little tax as possible. For those with significant wealth, this involves planning to avoid and minimize the estate tax given that the estate tax, when it applies, is often exceedingly large.

For example, consider the case of a wealthy business owner. Can the wealthy business owner avoid paying estate taxes by making a lifetime gift of an interest in a profitable S corporation to a child, and then deplete his or her estate by distributing all of the profits to the child every year? The answer is “maybe.” That is a common and known planning idea.

The Maggard court case adds to the concept by allowing the business owner to cause the corporation to distribute even more business profits to the child than he might have otherwise distributed. Given this court case, the business owner apparently does not need to worry that these excessive disproportionate distributions will result in a termination of the S corporation status.

Here’s how the tax treatment would work in this scenario:

The S corporation’s profits are allocated to shareholders based on their ownership percentages, regardless of actual distributions. Each shareholder reports their share of the profits on their individual tax return and pays tax on it.

When distributions are made, they are generally tax-free to the extent of the shareholder’s basis in their S corporation stock. The shareholder’s basis is increased by their share of the corporation’s income and decreased by distributions.

If a shareholder receives distributions in excess of their basis, the excess is treated as capital gain.

In our example:

The business owner would report and pay tax on their share of the S corporation’s profits, even if they didn’t receive any distribution.

The child would report and pay tax on their share of the S corporation’s profits.

The child would also receive the disproportionate distribution. This distribution would be tax-free up to the amount of their basis (which includes their share of the year’s profits). Any amount received in excess of their basis would be treated as capital gain.

There isn’t actually a “double tax” in this scenario. The business owner is taxed on their share of the profits (even though they didn’t receive a distribution), and the child is taxed on their share of the profits plus any distribution in excess of their basis. Each dollar of profit is taxed once, but the taxation doesn’t perfectly align with who received the cash.

This strategy could potentially provide estate planning benefits by allowing the business owner to shift value to the next generation (through the excess distributions) without triggering gift tax, while still maintaining their ownership percentage and control over the business. The business owner’s estate may be depleted over time as they pay taxes on phantom income (income allocated to them but distributed to the child).

This isn’t the only example of where this could apply. Consider the scenario where one of the business owners is in a high tax bracket and another owner is in a lower tax bracket. The corporation can apparently distribute more to the owner in the higher tax bracket while allowing the tax on the profits to be paid by the owner in the lower income tax bracket. However, the owner receiving the excess distribution would still need to pay tax on that excess amount. This strategy might be even more beneficial if the lower-bracket owner had an unused suspended capital loss carryforward that they could use up to offset any tax. This strategy could then reduce and eliminate taxes, resulting in an overall lower tax burden due to the difference in tax brackets and timing benefit of freeing up a suspended capital loss carryforward.

These are just a few examples of concepts that the Maggard court case could apply to. Creative tax planners will no doubt think of other uses for the case.

The Takeaway

This court case affirms that disproportionate distributions alone do not jeopardize S corporation status as long as governing documents provide for equal rights. On its face, this court case underscores the risks for minority shareholders, who may face tax liabilities on undistributed profits. Those interested in tax planning may also find this court case to be helpful. This ruling confirms a number of strategic tax planning, and potentially allows for more flexible wealth transfer and tax optimization strategies.